Subverting the Inversions: More Thoughts on Ending the Corporate Income Tax

I see that my friend Jared Bernstein has some more thoughtful (if mistaken) arguments on ending the corporate income tax. I recognize his concerns about giving more money to the people who have the most (hey, it’s the American Way), but I still think this is a policy that could be a big winner in the battle against the enemies of the people.

I will quickly address two issues Jared raised, the extent to which any of the savings will be passed on in wages and the ability to replace the revenue. However my main focus is the nature of the corporate tax avoidance industry. This is a pernicious drain of economic resources. It is also a major source of upward redistribution. I consider its elimination an enormous benefit – even if on net we give up some government revenue to do it.

First, I followed the Tax Policy Center in assuming that 20 percent of the benefits would go to workers in higher wages. Jared rightly pointed out that this will depend on workers bargaining power. However, it is worth noting that even in the worst of times workers have gotten some fraction of productivity gains. And if we look at the last year, the data show that average real hourly compensation increased almost as much as productivity growth (1.0 percent rise in real compensation versus a 1.2 percent increase in productivity). So the Tax Policy Center’s 20 percent pass back to wages hardly seems out of line.

The second question is how we would make up the lost revenue. The Congressional Budget Office (CBO) projects we will get $351 billion or 2.0 percent of GDP from the corporate income tax in 2014 (Table 4-1). This is the average for the next decade as well. Much of this can be gotten back from eliminating the special treatment of dividend and capital gains income. The major rationale for their special treatment was the argument that it amounted to double taxation since profits were already taxed at the corporate level. Since the corporate income tax will have been eliminated, there is no rationale for special treatment.

In 2012, the most recent year for which data is available, the Internal Revenue Service reported $260.4 billion in taxable dividend income and $2.217 trillion in capital gains distributions. If we assume an average increase of 10 percentage points in the tax rate on dividends and 5 percentage points in the effective tax rate on realized capital gains, this gets us $137 billion in tax revenue (26.0 billion from dividends and $111 billion from taxing capital gains). If we adjust this figure up by 10 percent to account for nominal growth from 2012 to 2014 we are up to $151 billion.

In addition, eliminating the corporate income tax will cause both sources of income to increase, which would imply a further increase in revenue. If half of profits are paid out in dividends (a bit less than the historic average) then we would see dividends increase by $175 billion (using the 2014 numbers), which at a 30 percent average tax rate gets us $53 billion in tax revenue.

The ending of the corporate income tax would increase after tax profits by around 25 percent, which presumably would lead to a corresponding increase in stock prices. That would lead to a one-time windfall for both stockholders and also the government in the form of capital gains tax revenue. However going forward stock prices should rise on average at the same pace but at base that is roughly 25 percent higher. In 2011 (sorry, most recent year I could find) the CBO projected capital gains income for 2014 of $103 billion. If we up that by 25 percent, it gets $26 billion.

This brings the total from additional capital income to $79 billion. Adding that to $151 billion from raising the tax rate, get us to $230 billion. Suppose we raise the top marginal rate by three percentage points. CBO projected that the ending of the Bush tax cut for high end individuals would raise $109 billion in 2014 (Table 3), so a three percentage point hike should get around half that, or $55 billion. That gets us to $285 billion, still a bit short of the $351 billion in lost corporate tax revenue, but it is within spitting distance.

I know all the tax increases mentioned here and others that could be added to the mix would arouse intense political opposition. I’ll come back to that point at the end.

Now let’s turn to the tax avoidance industry. There are two points to be made. First, this is a horrible entity that all right thinking people should want to see killed. Second, we would see a huge reduction in the size of the industry if we eliminated the corporate income tax.

On the first point, it is important to recognize that many of the highest income earners in the country make their money from gaming the tax system. As I noted before, the private equity industry, which currently has over $2 trillion in assets under management, is largely about gaming the tax code as shown in the new book by my colleague Eileen Appelbaum and Rose Batt. The people who design complex accounting schemes are often high end lawyers or accountants who can earn $500 an hour or more.

General Electric has a huge accounting department that exists to ensure that one of the most profitable companies in the history of the world consistently pays little or no taxes. Naturally these people are well-compensated. And when Burger King or some other major corporation is planning an inversion to end its U.S. tax liability altogether, Goldman Sachs or some other investment bank will make hundreds of millions in fees off the deal.

The tax avoidance industry employs many of the highest earners in the country. The M.I.T. economists call this explosion in job opportunities “skills-biased technical change” and tell everyone left behind that technology has made their skills obsolete. The reality has nothing to do with the skills bias of technology. It is about creating a Swiss cheese tax code that richly rewards the people who are best at finding the holes.

To get an idea of the money at stake, CBO projected corporate profits at 9.5 percent of GDP in 2014 (Table 2-1). If we actually collected the 35 percent corporate tax rate then the corporate income tax would be 3.3 percent of GDP. The 1.3 percentage points of GDP difference between this simple book rate and the 2.0 percent actually collected amounts to $230 billion of potential income for the tax avoidance industry. If half of savings to the tax avoiders and half is payments to the industry in various forms, they are pocketing $115 billion a year (0.65 percent of GDP) to game the tax code. This is a huge deal.

In response to this argument, Jared is concerned about the gaming system becoming even larger if we allow corporate income to go untaxed. He worries that people will shift their personal income to being corporate income and thereby escape taxation. He cites the evidence that small businesses are among the biggest tax evaders/avoiders.

There are two points to be made on this. First, there has been a conscious political decision to allow small business owners to cheat the tax code with impunity. It is a standard practice for small businesses to do things like depreciate the family SUV as a business expense. The I.R.S. could crack down on this, but there would be screams of bloody murder in Congress. (Very modest crackdowns in the Clinton years produced a Congressional inquisition that at one point led the I.R.S. to adopt a plan to audit auditors to ensure they weren’t abusing people.)

Whether this tax evasion is good or not, it is qualitatively different from the issues raised by allowing corporate income to go tax free. If the concern is that every Jared or Dean will incorporate as Jared.Inc or Dean.Inc, that could be easily prevented. It would be a simple matter to set some fee (e.g. $1 million a year) that would need to be paid to get tax exempt corporate status. This would be trivial to any major or even mid-size corporation, but it would prevent Jared or me and millions of other upper middle income people from trying to scam the system by incorporating.

The other side of this question is whether people will spend more on tax shelters now that they have more individual taxes to pay. The answer to this is almost certainly yes, but it is difficult to see this outcome creating a tax avoidance industry to rival the one being eliminated.

The very high end earners (say $20 million a year and above) are already paying clever accountants and tax lawyers to minimize their bills. Maybe they will blow a bit more money on this effort, but the increment is hardly going to be a hundred billion dollar industry.

We also have the little bit rich crowd, people who make $1-$2 million a year. These people will also spend a bit more avoiding taxes, but none of them have enough at stake to be paying millions of dollars a year to Goldman Sachs or Mitt Romney to devise clever schemes. To see this point, remember that someone earning $1 million a year now would probably face a comparable tax liability to someone currently earning $1.3 or $1.4 million. This latter group does not have qualitatively different behavior than the former group. In short, it seems like a safe bet that with some simple precautions a wholesale shift from personal income to corporate income can be prevented.

This brings us back to the politics question. Would the Republicans in Congress ever agree to a set of tax changes that were roughly revenue neutral and wiped out their friends in the tax avoidance industry? The answer is of course “hell no!” This is a political party that has as its guiding principle taking money from the rest of us and giving it to the rich.

However that is not a reason to not put forward what should be a very reasonable tax proposal that would sharply curtail waste while maintaining the progressivity of the tax code. We can certainly do better than the system we have now and highlighting what a better system might look like is an important step toward getting us there.

Addendum: I know these posts are supposed to get shorter as the exchange goes on. I promise the next one will follow the script.